Foreign Exchange Risk

What is Foreign Exchange Risk?

Foreign exchange risk, also known as exchange rate

risk, is the risk of financial impact due to exchange rate
fluctuations. In simpler terms, foreign exchange risk is
the risk that a business’ financial performance or
financial position will be impacted by changes in the
exchange rates between currencies.
Understanding Foreign Exchange Risk

The risk occurs when a company engages in financial

transactions or maintains financial statements in a currency
other than where it is headquartered. For example, a company
based in Pakistan that does business in China – i.e., receives
financial transactions in Chinese yuan – reports its financial
statements in Pakistani Rupees, is exposed to foreign exchange
risk.
The financial transactions, which are received in Chinese yuan,
must be converted to PKR to be reported on the company’s
financial statements. Changes in the exchange rate between the
Chinese yuan (foreign currency) and PKR (domestic currency)
would be the risk, hence the term foreign exchange risk.
Foreign exchange risk can be caused by appreciation/depreciation
of the base currency, appreciation/depreciation of the foreign
currency, or a combination of the two. It is a major risk to consider
for exporters/importers and businesses that trade in international
markets.
Types of Foreign Exchange Risk

1. Transaction risk
Transaction risk is the risk faced by a company when making financial transactions between
jurisdictions. The risk is the change in the exchange rate before transaction settlement.
Essentially, the time delay between transaction and settlement is the source of transaction
risk. Transaction risk can be mitigated using forward contracts and options.
 
For example, a Pakistani company with operations in China is looking to transfer CNY600 in
earnings to its Pakistani account. If the exchange rate at the time of the transaction was 1
PKR for 0.04 CNY, and the rate subsequently falls to 1 PKR for 0.05 CNY before settlement,
an expected receipt of PKR15000 (CNY600/0.04) would instead of PKR12000
(CNY600/0.05).
2. Economic risk
Economic risk, also known as forecast risk, is the risk that a company’s
market value is impacted by unavoidable exposure to exchange rate
fluctuations. Such a type of risk is usually created by macroeconomic
conditions such as geopolitical instability and/or government regulations.
 
For example, a Pakistani furniture company that sells locally will face
economic risk from furniture importers, especially if the Pakistani
currency unexpectedly strengthens.
3. Translation risk
Translation risk, also known as translation exposure, refers to the risk faced by a
company headquartered domestically but conducting business in a foreign jurisdiction,
and of which the company’s financial performance is denoted in its domestic currency.
Translation risk is higher when a company holds a greater portion of its assets,
liabilities, or equities in a foreign currency.
 
For example, a parent company that reports in Pakistani rupee but oversees a subsidiary
based in China faces translation risk, as the subsidiary’s financial performance – which
is in Chinese yuan – is translated into Pakistani rupee for reporting purposes.
Examples of Foreign Exchange Risk

Question 1: Company A, based in Canada, recently entered into an agreement to

purchase 10 advanced pieces of machinery from Company B, which is based in Europe.
The price per machinery is €10,000, and the exchange rate between the euro (€) and the
Canadian dollar ($) is 1:1. A week later, when Company A commits to purchasing the 10
pieces of machinery, the exchange rate between the euro and Canadian dollar changes to
1:1.2. Is it an example of transaction risk, economic risk, or translation risk?
Question 2: Company A, based in Canada, reports its financial statements in Canadian
dollars but conducts business in U.S. dollars. In other words, the company makes
financial transactions in United States dollars but reports in Canadian dollars. The
exchange rate between the Canadian dollar and the US dollar was 1:1 when the company
reported its Q1 financial results. However, it is now 1:1.2 when the company reported its
Q2 financial results. Is it an example of transaction risk, economic risk, or translation
risk?
• 1. Inflation Rates
• Changes in market inflation cause changes in currency
exchange rates. A country with a lower inflation rate than
another's will see an appreciation in the value of its currency.
The prices of goods and services increase at a slower rate
where the inflation is low. A country with a consistently lower
inflation rate exhibits a rising currency value while a country
with higher inflation typically sees depreciation in its
currency and is usually accompanied by higher interest rates
• 2. Interest Rates
• Changes in interest rate affect currency value and dollar
exchange rate. Forex rates, interest rates, and inflation are
all correlated. Increases in interest rates cause a country's
currency to appreciate because higher interest rates provide
higher rates to lenders, thereby attracting more foreign
capital, which causes a rise in exchange rates
• 3. Country’s Current Account / Balance of Payments
• A country’s current account reflects balance of trade and
earnings on foreign investment. It consists of total number
of transactions including its exports, imports, debt, etc. A
deficit in current account due to spending more of its
currency on importing products than it is earning through
sale of exports causes depreciation. Balance of payments
fluctuates exchange rate of its domestic currency.
• 4. Government Debt
• Government debt is public debt or national debt owned by
the central government. A country with government debt is
less likely to acquire foreign capital, leading to inflation.
Foreign investors will sell their bonds in the open market if
the market predicts government debt within a certain
country. As a result, a decrease in the value of its exchange
rate will follow.
• 5. Terms of Trade
• Related to current accounts and balance of payments, the
terms of trade is the ratio of export prices to import prices. A
country's terms of trade improves if its exports prices rise at
a greater rate than its imports prices. This results in higher
revenue, which causes a higher demand for the country's
currency and an increase in its currency's value. This results
in an appreciation of exchange rate.
• 6. Political Stability & Performance
• A country's political state and economic performance can
affect its currency strength. A country with less risk for
political turmoil is more attractive to foreign investors, as a
result, drawing investment away from other countries with
more political and economic stability. Increase in foreign
capital, in turn, leads to an appreciation in the value of its
domestic currency. A country with sound financial and trade
policy does not give any room for uncertainty in value of its
currency. But, a country prone to political confusions may see
a depreciation in exchange rates.
• 7. Recession
• When a country experiences a recession, its interest rates
are likely to fall, decreasing its chances to acquire foreign
capital. As a result, its currency weakens in comparison to
that of other countries, therefore lowering the exchange
rate.
• 8. Speculation
• If a country's currency value is expected to rise, investors will
demand more of that currency in order to make a profit in
the near future. As a result, the value of the currency will rise
due to the increase in demand. With this increase in
currency value comes a rise in the exchange rate as well.
• Conclusion:
All of these factors determine the foreign exchange rate
fluctuations. If you send or receive money frequently, being
up-to-date on these factors will help you better evaluate the
optimal time for international money transfer. To avoid any
potential falls in currency exchange rates, opt for a locked-in
exchange rate service, which will guarantee that your
currency is exchanged at the same rate despite any factors
that influence an unfavorable fluctuation.